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Monday, January 12, 2009

WHY SIP IS GOOD?

Systematic Investment Plans (SIPs) are much misunderstood. For one, investors often mistake SIPs as an investment avenue rather than a mode of investing in mutual funds. Then there are investors who invest in SIPs expecting quick results without fully appreciating the need to invest via SIPs for the long-term.

In an earlier article, we discussed how SIPs are perceived incorrectly by many investors as standalone investments. This explains why one of the most common queries we receive on the website is – which is the best SIP? Unfortunately, these investors have not been educated by their investment advisors about SIPs i.e. SIPs are only a mode of investing and not an independent investment avenue.

Minimum tenure of an SIPAnother misconception investors have about SIPs is with regards to the minimum tenure. Most fund houses have a minimum SIP tenure of 6 months. This leads investors to believe that 6 months is the ideal time frame for investing via SIPs (just like a lot of investors invest Rs 5,000 in mutual funds simply because that is the minimum investment amount for several mutual fund schemes).

In our view, investors should ideally invest via SIPs over at least 2-3 years. This way they can exploit the most critical benefit of an SIP – rupee cost averaging. Let’s understand how this is possible.

For an SIP to deliver the goods, it must witness a falling market. This way the investor can average out his cost of purchase. If the investor does not witness a downturn, i.e. he is only exposed to a market rally, the average purchase cost of his SIP will rise over a period of time.

SIPs in a rising market

Month of investment

NAV (Rs)

No. of Units

January

11.00

45.45

February

12.00

41.67

March

12.50

40.00

April

12.90

38.76

May

13.25

37.74

June

13.40

37.31

Avg. purchase cost of 6 SIPs

Rs 12.45

(The example is for illustrative purpose only.We have assumed that the SIP is done on the first trading day of the month; SIP amount is Rs 500.)

In the above table the average purchase cost of the SIP is Rs 12.45. Clearly, the SIP has not worked in the investor’s favour. Why is that? Because if he had instead invested lumpsum in January, his purchase cost would have been Rs 11.00 as opposed to the average purchase cost of Rs 12.45 over a 6-month period.

SIPs in a falling market

Month of investment

NAV (Rs)

No. of units

January

11.00

45.45

February

12.00

41.67

March

12.50

40.00

April

12.90

38.76

May

13.25

37.74

June

13.40

37.31

July

12.10

41.32

August

11.20

44.64

September

10.30

48.54

October

10.10

49.50

November

10.50

47.62

December

10.20

49.02

Avg. purchase cost of 12 SIPs

Rs 11.50

(The example is for illustrative purpose only.We have assumed that the SIP is done on the first trading day of the month; SIP amount is Rs 500.)

However, if the investor had opted for a longer investment tenure of say 12 months, he could have benefited from greater fluctuations in the mutual fund’s NAV. These fluctuations which arise over a market cycle lower the average purchase cost of the SIP over the long-term.

This is apparent from the above illustration. As is evident from the table, if the investor had taken an SIP for 12 months (instead of 6 months) his average purchase cost would have declined to Rs 11.50. Compare this with the average purchase cost of Rs 12.45 for a 6-month SIP.

It can be argued that there is no way for the investor to know when there is likely to be a turnaround in the markets (in this case a downturn). That is exactly our point. Since the investor does not know when markets will fall (and lower his average purchase cost), he must opt for a longer SIP tenure. Or at least he must manage his investments in a manner so that when his existing SIP terminates without witnessing a dip in stock markets, he can extend it further. This way should the markets fall, his SIP can benefit from a dip in the mutual fund NAV which in turn will lower his average purchase cost.

Points to remember before opting for an SIP

1) Ironically, while SIPs are meant to eliminate market-timing, investors must opt for a long-enough SIP tenure so as to ‘time’ the market downturn.

2) SIPs are equally beneficial in a falling market. Most investors believe that lumpsum investments (as opposed to SIPs) prove more beneficial in a falling market. This is only partly true. Having an SIP in operation during a falling market can ensure that investors stand to benefit should markets fall even further.

Also visit http://equityadvise.blogspot.com for an indepth Equity Analysis

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I am a Personal CFO who helps my investors plan for their LONGEST VACATION in their life......Their RETIREMENT!! All this with investments in Equities via Mutual Fund and this Blog is a small attempt to guide you too

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